Reading 47: Private Equity Valuation-LOS f 习题精选 2010, valuation, private, returns, following

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Session 13: Alternative Asset Valuation
Reading 47: Private Equity Valuation

LOS f: Explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns.

 

 

 

Which of the following is the least likely disadvantage in calculating the net asset value (NAV) for a private equity fund?

A) Only capital commitments already drawn down are included in the NAV calculation.

B) NAV may be difficult to calculate since firm values are not known with certainty prior to exit.

C) The limited partners use a third party to calculate the NAV of a private equity fund.

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NAV is usually calculated by the fund’s general partner, which could result in a subjective and inflated NAV. Limited partners, however, often use third party valuations to arrive at an objective and up-to-date NAV. This scenario thus describes a countermeasure to an issue in calculating NAV rather than a disadvantage itself.

The other two answers are both disadvantages in calculating NAV.

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The Dragonhill Group manages a $250 million private equity fund. Investors committed to a total of $300 million over the term of the fund and specified carried interest of 20% and a hurdle rate of 10%. Carried interest is distributed on a deal-by-deal basis. 60% of the $250 million has been invested at the beginning of year 1 in Deutsch Co. (Deutsch), with the remaining 40% invested in Reiner Ltd (Reiner).

Both firms are sold at the end of the third year, realizing a $45 million profit for Deutsch and a $35 million profit for Reiner.

The carried interest paid to the fund’s general partner after Deutsch and Reiner, respectively, is:

Deutsch

Reiner

A) $9 million $0

B) $9 million $7 million

C) $0 $7 million

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Since carried interest is paid on a deal-by-deal basis, profits are not netted. Also, carried interest is only paid if the investment’s IRR at least meets the hurdle rate of 10%.

(All figures are in $ million):
The initial allocation between the firms was:
Deutsch: (0.60)($250) = $150
Reiner: (0.40)($250) = $100

The IRRs for the two firms are:
IRRDeutsch: PV = -$150; FV = $195, N = 3; CPT I/Y → IRR = 9.14%.
IRRReiner: PV = -$100; FV = $135; N = 3; CPT I/Y → IRR = 10.52%.

Since the return on Deutsch fell short of the 10% hurdle rate, the general partner only receives profits after Reiner. The profit is 20% of $35 million, or $7 million.

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With regard to Statement 3 and 4 on terminal value projections of the venture capital and LBO investments, respectively, Athos is:

A) incorrect on Statement 3 since the IRR method is useful in obtaining present value projections but cannot be used as a tool to compute the future expected wealth of a venture capital investor.

B) correct on both statements.

C) incorrect on Statement 4 since the free cash flow method and the sales or earnings multiples are not useful for investments financed to a large extent by debt.

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Statement 3 is correct. One way to visualize the IRR method is to think of the venture capital method using NPV in reverse. With the IRR method, the investor’s present investment is compounded at the IRR rate over t (number of years to exit) to arrive at the investor’s expected future wealth.

Statement 4 is also correct. Private equity firms frequently use the free cash flow or a sales or earnings multiple approach to project terminal values. Debt (both junior and senior) is factored into these calculations.

For answers to questions 3-5, refer to the following table:

Fund Cash Flows
	Capital Called Down	Operating Results	Mgmt Fees	NAV before Distributions	Carried Interest	Distributions	NAV after Distributions
2004	200	-40	3.0	157.0			157.0
2005	100	-70	4.5	182.5			182.5
2006	100	100	6.0	376.5		70	306.5
2007	50	180	6.8	529.8	7.4	100	422.3
2008	50	250	7.5	714.8	46.3	150	518.5

Management fees are 1.50% of cumulative called down capital (paid-in capital).

NAV before distributions for any year is the NAV after distributions of the prior year, plus new capital called down, plus operating results, less management fees.

Carried interest is discussed below.

NAV after distributions for any year is NAV before distributions less carried interest less any distributions. (Study Session 13, LOS 48.l,p)

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Based on information in the table above, management fees and carried interest, respectively, in 2007 will be closest to (in $ millions):

Management Fee

Carried Interest

A) $0.75 $8.90

B) $6.80 $7.45

C) $3.50 $8.30

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2007 management fees are calculated as 1.50% of paid-in capital. 2007 paid-in capital is $200 + $100 + $100 + $50 = $450. Management fees are 1.50% of $450, or $6.75.

Carried interest is the general partner’s share of fund profits. It is calculated based on the total return (NAV before distributions) method using committed capital. Total capital commitment by investors is $500 million. In 2007 NAV before distributions was $529.8, exceeding committed capital for the first time.

Carried interest is 25% of NAV before distributions less committed capital, or (0.25)($529.8 ? $500) = $7.45. (Study Session 13, LOS 48.g,i)

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Carried interest to the fund’s partners will first be paid out in:

A) 2006.

B) 2008.

C) 2007.

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Carried interest is paid to the general partners based on the total return method using committed capital. Carried interest will thus be only paid when total return (as measured by NAV before distributions) exceeds the committed capital of $500 million. The first year that carried interest would be paid is 2007. (Study Session 13, LOS 48.g,i)

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The fund’s distributed to paid in capital (DPI) and residual value to paid in capital (RVPI) multiples, respectively, for 2008 will be closest to:

DPI

RVPI

A) 0.30 1.43

B) 0.64 1.02

C) 3.00 1.43

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DPI measures the limited partners’ (LPs’) realized return in the fund. DPI is calculated as the cumulative distributions divided by the paid-in capital. Cumulative distributions for 2008 were $150 + $100 + $70 = $320. Paid-in capital in 2008 was $200 + $100 + $100 + $50 + $50 = $500.

The ratio of cumulative distributions to paid-in capital is $320/$500 = 0.64

RVPI measures the LPs’ unrealized return in the fund. It is calculated by dividing the NAV after distributions by the paid-in capital. NAV after distributions in 2008 was $511.1.

The ratio of NAV after distributions to paid-in capital is $511.1/$500 = 1.022 (Study Session 13, LOS 48.h,i)

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Regarding the potential acquisition targets discussed by Athos and Brie, the venture capital firm’s discount rate adjusted for failure, and the LBO company’s equity beta, respectively, are closest to:

Adjusted discount rate

LBO's equity beta

A) 92.31% 1.80

B) 71.43% 0.45

C) 71.43% 1.35

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The venture capital firm's discount rate adjusted for the probability of failure is calculated as follows:

The LBO company's equity beta is calculated based on the following formula:

Note: in answer B, the discount rate was calculated as:

For the LBO firm, one answer was calculated using:

While another used:

(Study Session 13, LOS 48.m,q)

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The pair of terms that correctly identifies the method of profit distribution between limited partners (LPs) and general partners (GPs), and the allocation of equity between shareholders and management of a portfolio company, respectively, is:

Method of profit distribution

Equity allocation

A) Distribution waterfall Ratchet

B) Ratchet Carried interest

C) Carried interest Distribution waterfall

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Distribution waterfall identifies the profit allocation between LPs and GPs and specifies when GPs can receive carried interest. Ratchet refers to the equity allocation between shareholders and management. Carried interest is the GP’s share in fund profits.

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The party in a private equity fund that has unlimited liability for the firm’s debts, and this party’s share in fund profits, respectively, is referred to as:

Unlimited liability

Share in fund profits

A) Limited partner Distribution waterfall

B) General partner Carried interest

C) Manager Management fees

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Limited partners’ liability does not extend beyond their capital investment, whereas general partners (the fund managers) have unlimited liability for the firm’s debt. The general partner’s share in fund profits is referred to as carried interest. Management fees are paid annually as a percentage of capital (NAV, paid-in-capital, or committed capital) and are not tied to fund profits.

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RDO is a private equity fund with $50 million in committed capital and an investment in three portfolio companies totalling $30 million. The fund earned a healthy profit of $5 million after its first year on the sale of one of the companies but suffered a $2 million loss after its second year on the sale of the second company. The fund pays carried interest of 20% on a total return basis using committed capital and also has a clawback provision.

The clawback the general partner must pay at the end of the second year is:

A) $0.

B) $400,000.

C) $600,000.

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A clawback provision in a private equity prospectus requires the general partner to repay part of previously distributed profits if the fund subsequently underperforms.

Since carried interest is paid on a total return basis using committed capital, the general partner of RDO would only receive interest when the portfolio value exceeds committed capital ($50 million). First-year profit is $5 million, bringing the portfolio value to $35 million, therefore no carried interest is paid. Since no profit was distributed to the general partner in the first year, a clawback does not apply in the second year.